Recently in Federal Reserve 2008 Category

Full text of speech at the Fed's website.

Here's the money quote:

Regarding interest rate policy, although further reductions from the current federal funds rate target of 1 percent are certainly feasible, at this point the scope for using conventional interest rate policies to support the economy is obviously limited. Indeed, the actual federal funds rate has been trading consistently below the Committee's 1 percent target in recent weeks, reflecting the large quantity of reserves that our lending activities have put into the system. In principle, our ability to pay interest on excess reserves at a rate equal to the funds rate target, as we have been doing, should keep the actual rate near the target, because banks should have no incentive to lend overnight funds at a rate lower than what they can receive from the Federal Reserve. In practice, however, several factors have served to depress the market rate below the target. One such factor is the presence in the market of large suppliers of funds, notably the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which are not eligible to receive interest on reserves and are thus willing to lend overnight federal funds at rates below the target. We will continue to explore ways to keep the effective federal funds rate closer to the target.

Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Federal Reserve's quiver--the provision of liquidity--remains effective. Indeed, there are several means by which the Fed could influence financial conditions through the use of its balance sheet, beyond expanding our lending to financial institutions. First, the Fed could purchase longer-term Treasury or agency securities on the open market in substantial quantities. This approach might influence the yields on these securities, thus helping to spur aggregate demand. Indeed, last week the Fed announced plans to purchase up to $100 billion in GSE debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters. It is encouraging that the announcement of that action was met by a fall in mortgage interest rates.

Translation:  They're not done yet.

T.S. Eliot wrote that April is the cruelest month.  In the academic year, November shares some similarities with April in that it's when we start to come to grips with the fact that this semester will end... and soon.  For me, blogging seems to take a hit in November.  I'd tell you what's been keeping me busy, but it really is academic minutiae.  You'd be bored to tears.

November has been a cruel month for the markets as well, especially the last couple days.  Some days I turn on CNBC and literally see things that I never thought I'd see.  Watching the 30 year Treasury yield take a dive like it did yesterday would be one of those things.  Seeing Citi at less than $4 would be another.  Hearing perfectly reasonable people fret about the possibility of deflation would be still another.

How do you title a blog post these days without sounding like a doom-and-gloomer?  I feel like I want to choose my words very carefully to avoid making things seem worse than they are.  (I know how you feel, King!)  But when you hear speculations of a pretty sizeable drop in GDP in the 4th quarter and graphs showing this to be the worst stock market decline since the Great Depression, it's easy to get caught up in it.

So as I work my way back into the swing of things over this Thanksgiving break, let's just set the stage.

The auto bailout:  Not a good idea, but probably going to happen in some way, shape, or form.  At the rate that they're burning cash, I don't see what a bailout would reasonably hope to accomplish.  A fast track to a government assisted bankruptcy would probably be better in the long run.  I would support proposals to protect the pensions of workers, especially those near retirement because that represents a past promise that people took into account when making decisions. That's probably a good topic for a future post.  But this decline has been a long time coming, and trying to stop it is just going to add to the problems later.

Paulson's reversal:  I, for one, found that episode at least somewhat refreshing.  Some say that he realized that $700 billion would not be nearly enough.  Perhaps.  But if that's the case, I'd rather he stopped at the brink of the canyon like he did rather than jumping in and then telling us.  Yes, we could use some more transparency in seeing where the money has gone so far.  But most importantly, the fact that they're holding back some of that money means that at least one agency is doing something to keep its powder dry.  Which brings us to...

What will the Fed do in December?   That's what my macro classes are working on figuring out.  After Thanksgiving, I'll be discussing Poole's 1970 QJE paper with my grad students.  I guess that will be as good a time as any to bring up this development: (Bloomberg)

``There has been a policy shift, but the Fed is not transparently announcing what it is doing and why,'' said former St. Louis Fed President William Poole, now a senior fellow at Cato. ``Monetary policy works best when the markets understand what the central bank is doing.''

Some analysts point to the surplus cash that banks keep on deposit at the Fed as a key gauge of the Fed's monetary-policy stance. The so-called excess reserves have ballooned to $363.6 billion from $2 billion in August as the Fed added to its emergency lending programs.

``It is a move to quantitative easing, to force lots and lots of reserves into the banking system with the expectation that banks will start to trade them for a higher-yielding asset,'' said Poole, a Bloomberg contributor, said yesterday in a Bloomberg Television interview.

Hat tip to Calculated Risk.

Indeed, when you see things like this, it makes you wonder what is going on.  I'm going to be thinking about that a lot this week during the break from classes.

So what about deflation?  I'm not in the camp that thinks it's a big problem yet.  It becomes a real problem if wage declines make it even more difficult for people to make their mortgage payments or if price declines are so widespread and expected that people hold off spending now as they expect prices to go down further.  I don't see us getting there yet, but I stand ready to revise my expectations as new data arrives.

And finally stock market:  I'm just as caught up in it as you are.  My explanations are no better than anyone else's.  It does appear that we're on the verge of something with Citi, and people are getting worried about commercial real estate.  Those make for some strong headwinds. 

As I go around town I hear comments both positive and negative.  Everyone complains about their 401(k)s, but local businesses are hiring.  I do think that we're in a recession as we would define one nationally.  However, the impact is going to be very different for various regions and economic sectors.  It's difficult to fight recessions like this because it becomes more tempting to try to target policies at one area or another, and that's not always good or successful.

But it does give us things to talk about.

FOMC press release:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 1 percent.

The pace of economic activity appears to have slowed markedly, owing importantly to a decline in consumer expenditures. Business equipment spending and industrial production have weakened in recent months, and slowing economic activity in many foreign economies is damping the prospects for U.S. exports. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit.

In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate in coming quarters to levels consistent with price stability.

Recent policy actions, including today's rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth. Nevertheless, downside risks to growth remain. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 1-1/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Cleveland, and San Francisco.

There are some new features in the exact wording, such as "the Committee expects inflation to moderate in coming quarters to levels consistent with price stability".  Seems like only six weeks ago that they expected "inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain."

Greg Mankiw has a good idea on how to recapitalize the ailing financial sector.  Read the whole thing.

Readers wondering about why coordination among central bankers matters (as in today's coordinated rate cut) may benefit from this old post from 2006.  The subject is a NY Times piece by Hal Varian.

Since this is such an unusual event, I'm just going to print the entire press release complete with links to other central banks.

Joint Statement by Central Banks

Throughout the current financial crisis, central banks have engaged in continuous close consultation and have cooperated in unprecedented joint actions such as the provision of liquidity to reduce strains in financial markets.

Inflationary pressures have started to moderate in a number of countries, partly reflecting a marked decline in energy and other commodity prices. Inflation expectations are diminishing and remain anchored to price stability. The recent intensification of the financial crisis has augmented the downside risks to growth and thus has diminished further the upside risks to price stability. 

Some easing of global monetary conditions is therefore warranted. Accordingly, the Bank of Canada, the Bank of England, the European Central Bank, the Federal Reserve, Sveriges Riksbank, and the Swiss National Bank are today announcing reductions in policy interest rates. The Bank of Japan expresses its strong support of these policy actions.

Federal Reserve Actions
The Federal Open Market Committee has decided to lower its target for the federal funds rate 50 basis points to 1-1/2 percent. The Committee took this action in light of evidence pointing to a weakening of economic activity and a reduction in inflationary pressures. 

Incoming economic data suggest that the pace of economic activity has slowed markedly in recent months. Moreover, the intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit. Inflation has been high, but the Committee believes that the decline in energy and other commodity prices and the weaker prospects for economic activity have reduced the upside risks to inflation. 

The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability. 

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. 

In a related action, the Board of Governors unanimously approved a 50-basis-point decrease in the discount rate to 1-3/4 percent.  In taking this action, the Board approved the request submitted by the Board of Directors of the Federal Reserve Bank of Boston.

Information on Actions Taken by Other Central Banks
Information on the actions that will be taken by other central banks is available at the following websites:

Bank of Canada
Bank of England
European Central Bank
Sveriges Riksbank (Bank of Sweden)
Swiss National Bank (51 KB PDF) 

Statements by Other Central Banks
Bank of Japan (65 KB PDF)

David Altig takes up the question with links back to Marginal Revolution, DeLong, as well as my post from yesterday.  (Thanks, David!)

Rather than looking at it as what DeLong calls "Operation Twist", Altig opts for the simpler explanation that it will put a lower bound on the effective fed funds rate.  That is, of course, the fundamental effect that this would have in any circumstance--crisis or not.  It puts the Fed in as the residual buyer of the funds and thus establishes the floor.

The apparent lack of a (non-zero) lower bound on the funds rate was first noticed over a year ago when there were trades happening at zero percent.  Here's what I said in August 2007:

So while I don't have a full and definitive explanation [for the zero percent transactions], it would seem that borrower risk is a factor, and the fact that these are excess reserves (which earn no interest) is also a factor. In that case, the low end of the range could stay low until the reserve picture gets back to normal.

When the Fed began discussing it more seriously in May 2008, I said:

I'll go on the record that this is a good idea. It will help to smooth out the recent fluctuations in the funds rate that garnered so much consternation at this blog among other places. It would prevent interest rate policy from getting in the way of policies for directly injecting liquidity into the financial markets by effectively keeping a floor on the funds rate even during a big injection of liquidity.

So I am clearly on board with the stated reasoning behind the move.  Plus, I think it's just a good policy to eliminate what is effectively a tax on reserves.

But I was struck by DeLong's comment about open market operations on the risk premium rather than on the liquidity premium.  The more this drags on and the more we learn, the more I am coming to the conclusion (see here, for example) that this is a problem with the risk premium.  Why else would the CP market freeze up despite the massive injections of liquidity, not to mention the CDS market?  There seems to be a lot of liquidity out there, but it's not necessarily getting to where it needs to go.

And that got me wondering if paying interest on reserves might, as Tabarrok suggested, accomplish the goal of getting that liquidity where it needs to go in an Operation Twist sort of way.  While the Fed is not yet targeting particular assets, we're treading very close to the kind of environment where that might be necessary.  (Have you seen a T-bill rate lately?)  Having the ability to pay interest on reserves would not be counter to that purpose, even if it wasn't the primary reason.  Of course, it should also be noted that the paying of interest on reserves is a permanent change rather than a temporary one meant only for the crisis.

Paying interest on reserves is a good policy for a lot of reasons.  The obvious ones and the ones that might still be a stretch--at least for now.

Press Release from the Fed:

The Federal Reserve Board on Tuesday announced the creation of the Commercial Paper Funding Facility (CPFF), a facility that will complement the Federal Reserve's existing credit facilities to help provide liquidity to term funding markets. The CPFF will provide a liquidity backstop to U.S. issuers of commercial paper through a special purpose vehicle (SPV) that will purchase three-month unsecured and asset-backed commercial paper directly from eligible issuers. The Federal Reserve will provide financing to the SPV under the CPFF and will be secured by all of the assets of the SPV and, in the case of commercial paper that is not asset-backed commercial paper, by the retention of up-front fees paid by the issuers or by other forms of security acceptable to the Federal Reserve in consultation with market participants. The Treasury believes this facility is necessary to prevent substantial disruptions to the financial markets and the economy and will make a special deposit at the Federal Reserve Bank of New York in support of this facility.

The commercial paper market has been under considerable strain in recent weeks as money market mutual funds and other investors, themselves often facing liquidity pressures, have become increasingly reluctant to purchase commercial paper, especially at longer-dated maturities. As a result, the volume of outstanding commercial paper has shrunk, interest rates on longer-term commercial paper have increased significantly, and an increasingly high percentage of outstanding paper must now be refinanced each day. A large share of outstanding commercial paper is issued or sponsored by financial intermediaries, and their difficulties placing commercial paper have made it more difficult for those intermediaries to play their vital role in meeting the credit needs of businesses and households.

By eliminating much of the risk that eligible issuers will not be able to repay investors by rolling over their maturing commercial paper obligations, this facility should encourage investors to once again engage in term lending in the commercial paper market. Added investor demand should lower commercial paper rates from their current elevated levels and foster issuance of longer-term commercial paper. An improved commercial paper market will enhance the ability of financial intermediaries to accommodate the credit needs of businesses and households.

This will bring a sigh of relief to the commercial paper market. Think of it this way.  The Fed is betting that there are a lot of mutually beneficial trades out there that are not happening because the participants either afraid that they will not get paid back or that they will not be able to liquidate the paper they hold if they need quick cash.  In normal times this action would not be necessary.  But these are not normal times.  John Jansen at Across the Curve has been reporting on the CP market for a while, and if what he's been saying is true then this was a very smart and very necessary move.

So says Reuters (and CNBC)

The statement came after U.S. business television channel CNBC reported the Fed was planning talks with the Chicago Mercantile Exchange, or CME, and the Intercontinental Exchange, or ICE, on the creation of a CDS exchange. The companies declined to confirm the report, although they said they would be willing to participate in any initiative.

And Calculated Risk says:

Apparently CNBC's Steve Leisman reported (I didn't see it) that the Fed might announce tomorrow morning some sort of program to buy commercial paper.

I had CNBC on in the background tonight and I think I heard that as well.  John Jansen says he has heard something to that effect from three sources.  And if you haven't been reading his blog lately, you're not fully informed.  From what I'm reading at his blog and other sources, it appears that the levels of risk aversion out there are just incredible.  Institutions are not lending because they have no way to assess the creditworthiness of their counterparties.  As a result, good trades are being passed over.  This cannot go on for very long without causing some significant problems. 

As I've said before, it's an information problem (which has led to a problem of risk assessment).  We are in need of transparency, pure and simple.  Unfortunately, getting it will not be that simple.

From the Federal Reserve:

The Financial Services Regulatory Relief Act of 2006 originally authorized the Federal Reserve to begin paying interest on balances held by or on behalf of depository institutions beginning October 1, 2011. The recently enacted Emergency Economic Stabilization Act of 2008 accelerated the effective date to October 1, 2008. 

Employing the accelerated authority, the Board has approved a rule to amend its Regulation D (Reserve Requirements of Depository Institutions) to direct the Federal Reserve Banks to pay interest on required reserve balances (that is, balances held to satisfy depository institutions' reserve requirements) and on excess balances (balances held in excess of required reserve balances and clearing balances). 

The interest rate paid on required reserve balances will be the average targeted federal funds rate established by the Federal Open Market Committee over each reserve maintenance period less 10 basis points. Paying interest on required reserve balances should essentially eliminate the opportunity cost of holding required reserves, promoting efficiency in the banking sector. 

The rate paid on excess balances will be set initially as the lowest targeted federal funds rate for each reserve maintenance period less 75 basis points. Paying interest on excess balances should help to establish a lower bound on the federal funds rate. The formula for the interest rate on excess balances may be adjusted subsequently in light of experience and evolving market conditions. The payment of interest on excess reserves will permit the Federal Reserve to expand its balance sheet as necessary to provide the liquidity necessary to support financial stability while implementing the monetary policy that is appropriate in light of the System's macroeconomic objectives of maximum employment and price stability.

Tyler Cowen thinks it is what Brad DeLong suggested as "Operation Twist on a Pan-Galactic scale."  I agree.  The effect will be small, but it probably won't hurt.

Alex Tabarrok at Marginal Revolution writes:

The consensus among economists is now clear, the best strategy for dealing with the financial crisis is to recapitalize the banks that need recapitalization.  Paul Krugman, John Cochrane, Luigi Zingales, Douglas Diamond, Raghuram Rajan and many others all advocate some form of recapitalization as do Tyler Cowen and myself.  Krugman would prefer a recapitalization in the form of nationalization.  In my view, there is still plenty of private money to buy banks at the right price and my preferred model is the FDIC leading a speed bankruptcy procedure, as was done brilliantly with Washington Mutual (Cochrane also supports this model.)  In the middle are most of the others who have a variety of good ideas to require the banks to raise equity in various ways.

...

There is also a consensus among economists that the bailout bill is not the right policy.  None of the above economists, for example, is enthusiastic about the bailout.  My bet is that all of us think that the bailout has a substantial likelihood of failing.  The support that exists is born out of hope and fear not judgment and experience.  Nevertheless, the political consensus is that a bailout is what we will get whether it is likely to work or not.  

Count me among those not enthusiastic.  My grudging support is not out of fear, per se--that's too strong a word.  Rather, I am convinced that we're in for a bumpy ride either way, and even a suboptimal plan like this has the potential to make the ride less bumpy.  Furthermore, I think that the moral hazard risks are small in the short term, and there is plenty of time to deal with the long term later.

But what is done is done.  Payrolls fell another 159,000 in September.  The unemployment rate did not rise this month, but it will catch up in time.  And let's be clear once again.  This bailout bill will not prevent a recession.  As James Hamilton says, that's a "done deal".  This bill will not restore calm to the financial markets either.  The best we can hope for out of this bill is that it can help facilitate the revealing of information in the markets sooner than would take place without it.  That might prevent an unnecessarily protracted downturn.

You won't find me celebrating this bill, but I am looking ahead with anticipation to see if it can get counterparties trading with each other again.  If it can do that, it will achieve some measure of success.

It's a familiar phrase to anyone who regularly reads legislation.  Most people would call it "pork."  It's the extra stuff that goes into a bill to make it palatable to legislators who are not totally in favor of the main purpose of the bill.  These items are not necessarily enough to convert a staunch opponent, but enough to get those on the fence to come to your side.  It's a political application of the economist's old friend, "thinking on the margin."

With that as prelude, I offer you this link to the bill passed by the Senate and now before the House.  It is now 442 pages long.  The pork "other purposes," begin on page 110 and continues for the next 330 pages (there are a couple of essentially blank pages at the end).  The math works out nicely to be 75% "other purposes" by volume though not by money.

Ever since this latest and most intense phase of the ongoing crisis began a few weeks ago, I have been convinced of the need for a coordinated approach to unclogging the credit markets.  Efforts to manage the specific incidents (AIG, WaMu, etc.) have been generally pretty good--if pretty good means that there have been no runs on banks and no catastrophic failure of the financial system.  In fact, as I have pointed out in a couple of media interviews lately, the response of the FDIC has been superb.  So far, they have my vote for the "most valuable player" in the handling of the situation.  Because of their experience and efficiency in handling bank failures, I would fully support a measure that would guarantee that FDIC continues to have access to the Treasury to meet its mission.  FDIC was created for just this sort of thing, so let's utilize them.

But there is a limit to what FDIC can do.  The Fed can do a little bit more.  They have the authority to respond to emergencies by lending to entities outside their normal purview.  While there is always a danger that such authority could be used unnecessarily, in my estimation they have acted responsibly thus far.  But even the Fed is limited to the role of responding to emergencies rather than acting entirely proactively.  To act more proactively, that is, to systematically purchase troubled assets in a way that many think needs to be done, requires Congressional authority.  And that's why we're here having this discussion.

There are, however, many reasons to be cautious about granting that authority.  Obviously it requires transparency and oversight.  Provisions that limit golden parachutes and give the taxpayer a chance to share the upside are also unobjectionable to me.  Assessing financial institutions for a portion of the costs is also a good idea.  Handing the Treasury Secretary a blank check would clearly be a very bad idea.

The biggest problem right now is clearly a lack of information (asymmetric information as well, but in some cases it is truly lacking).  It is evident from the TED spread and other data that lending among the major institutions is being constrained by uncertainty over how to assess counterparty risk.  This is not healthy, and it's not going to go away until some more information is revealed.  Any bailout package should be designed with that in mind.  If the Treasury is allowed to take some of the bad assets off of a bank, it may send a signal to counterparties that they are less risky.  This would help to get funds moving again.

And let me just head off anyone who would say that we don't need to "get funds moving again" because that's what got us into that mess.  That's just wrong.  Getting the counterparties creditworthy again will not create an undue amount of moral hazard.  This market has been slammed--big time.  Getting the funds moving in a more normal way will not bring about a return to subprime, interest only, no-doc loans.  At least not for a long time, and in that time we can talk about smart regulation to prevent that from happening again.

In summary, here's what I like about the proposal going through Congress:

• Wall Street shares the cost (see pages 9-12 of the legislation)
• Limits on executive compensation
• Making the $700 billion available in tranches

Things I don't like as much:

• A temporary increase in the $100,000 per account limit on FDIC insurance to $250,000.  Why?  I don't like fiddling with such important institutions on a temporary basis.  That figure is due for an upward adjustment due to inflation (and an increase in the premiums banks pay).  Why not do that and make it permanent?  (UPDATE:  But don't do it during the crisis, see below).
  
• Ability of the Treasury to suspend mark-to-market rules.  Why?  Similar reasoning.  I rarely would favor a temporary change in rules that are meant to foster transparency.  Mark-to-market may be flawed, but I'm afraid that temporarily suspending it right now would only add to the confusion.

Things I just don't like:

• "...and for other purposes"  Why?  You figure it out.  (Look at page 294 for an example.)
  

Is this legislation better than nothing?  All week I've been wanting to be able to say yes, but I am finding it difficult to do so.  There is something to be said for having a plan in place in case we need it in the next three months that Congress is out of session.  And yet, I find myself disappointed in the process and not that crazy about the final product.

There is no doubt in my mind that on balance this legislation is worse than what was voted down on Monday, but this one might actually pass.  That's how Congress works.  This legislation is not something that we urgently need to prevent a depression, and it simply will not prevent whatever recession may be in the works.  If it passes, it might reduce some of the anxiety in the credit market sooner.  If it fails, the Fed will probably be called on to use its emergency lending authority again.  The latter is not optimal, but it is probably workable.

The really sad thing is that the "other purposes" are not really out of the normal realm of business.  While it grates at me, it is part of the legislative game.  But if you think that facilitating price discovery and getting institutions to show their cards well help reduce counterparty risk, then this might be the best plan you'll get.  It's not a solution.  A solution seems very far away at the moment.  But it's probably marginally better than doing nothing and hoping for the best.

And I think I'll just leave it at that.

For today's other commentary, see Arnold Kling (who has had very good material lately) and Tyler Cowen (with whom I am in general agreement).

UPDATE:  King Banaian doesn't like the increase in the FDIC limit either.  He is worried about the moral hazard and that it would lead to banks taking more risks to try to recover their losses (as in what led up to the S&L crisis).  He's right about that.  I still think the temporary aspect of it makes it worse.  Let me be clear.  I think the limit should be increased permanently to adjust for inflation, but it does not need to be done in this bill.  It is not an urgent matter.  And furthermore, if and when the limit is raised, the insurance premiums paid by banks should increase as well.  In the meantime, the present practice of the FDIC in insuring the first $100,000 with certainty and making any decision to insure deposits beyond that on a case-by-case basis is sufficient for now.

...is by David Altig.  (Though some of his commenters have dissenting views.)

Five days ago, I wrote:

So I am fairly confident that a "workable" solution will be reached before the markets open on Monday.  I do not look for an "optimal" solution.  If an optimal solution exists, it is undoubtedly too complicated to be "workable".  But I believe that a number of ideas on the table have the potential to avert a complete meltdown.  I think that when all the parties (including both McCain and Obama) meet behind closed doors and really come to grips with the magnitude of the problem and the fact that a workable solution exists, we'll get one.

I sure hope I'm right.

I was wrong.  At least for now.  There's always the possibility that something will happen later this week.  I don't know what the likelihood is.  Obviously the party whips don't know either--and they're the ones who should. 

At the moment, the way I am organizing my thoughts about the situation is in the form of questions and answers.  So here are the questions I've been asking myself, and my best attempts at some answers.

Q:  Did we need this bill?
A:  I would be careful not to say that we needed this bill.  That is, neither this bill nor any bill was or is a necessary condition for preventing financial Armageddon.  Certainly there were some other options out there other than this bill that I may have preferred.  But after the bill failed, the Federal Reserve announced additional lending measures.  This represents another stop-gap measure that hopefully will help us limp through tomorrow.  The Fed could (with the assistance of special treasury issues) continue to do this for some time.  But of course this is not what we like to see either.  It would be nice to get a legislative solution.  However, if Congress is too dysfunctional to do it, then so be it.  There are other ways.

Q:  What is the biggest mistake that Congress and others are making?
A:  Actually, I see two misconceptions being perpetrated out there.  One is the framing of this issue as Wall Street versus Main Street.  That is, that the government is taking from Joe Six-Pack to give to big bankers.  On the other side of the aisle, there are those who oppose this or any "bailout" out of an unwavering commitment to free market principles.  That is, the bailout is just socialism by another name and should be rejected outright.

Both views have an element of truth, but both views also miss the point.  I think most of my readers understand the connection between Wall Street and Main Street.  However, it is becoming clearer that many people have never made that connection.  And let's be clear, it's not about the stock market!  The fact that the stock market dropped over 700 points is a symptom--not the disease.  The reason to do the deal is not to prop up the stock market--though that certainly gets (and deserves) a lot of attention.  But the drop in the stock market is just an indicator of the drying up of liquidity.  If you doubt this, just read John Jansen's excellent blog (Across the Curve).  If this continues for much longer, it WILL cause firms to have difficulty meeting payroll, paying for inventory, and financing expansion.  At that point, Main Street is affected.  That is what happened in the Great Depression in a very big way.  We may be able to stave off a Great Depression, but there is the potential for a very severe recession.

Those who say the bailout is socialism may say that a severe recession may be the price we have to pay and is not an excuse for such an intervention.  I understand this argument, and it is not entirely without merit.  If the situation, as I understand it to be, was less dire, I might even agree.  But Ben Bernanke is a student of the Great Depression.  If he's worried, then I am too.  My own study of history tells me that this is the closest we have come to such a scenario since the Great Depression.  So I am willing to put aside the "bailout is socialism" argument and argue that a strong government response is warranted.

Let's take a look at some very smart words from Robert Shiller, an economist that I respect a great deal:

So is the government's bailout a major departure? Hardly. Today's federal involvement offers bailouts as a strictly temporary measure to prevent a system-wide financial calamity. This is entirely in keeping with our basic principles -- as long as the bailout promotes, rather than hinders, financial democracy.

Which, so far, it seems to. Congressional critics may be right to demand more help for homeowners and more accountability for Wall Street blunders, but the core idea of the plan is sound: to protect the financial infrastructure. Remember, Fannie Mae used to be a government entity, and by taking it over, the federal government is merely returning to the status quo ante. The measures to take toxic debts off the hands of financial and insurance firms are intended only to deal with a crisis, not to transform our financial system. The proposals do not represent any landmark change in the American way of prosperity. Everyone should take a deep breath. Changing our thinking about finance does not mean abolishing capitalism, but it does raise questions about what the changes mean.

Indeed.  Whatever "bailout" happens, if any, it will not be a permanent intrusion of socialism into the financial markets.  In fact, this represents a tremendous opportunity to modernize the financial system.  By "modernize", I don't mean the kind of derivatives that got us into trouble, but rather a sensible set of regulations that acknowledge the moral hazard problem and prevent institutions from doubling-down on a bad bet.  Read the rest of Shiller's column for more specifics.  I agree with his assessment.

This is a profoundly unique moment in our financial history.  The Fed and the Treasury will do what they can with or without Congress--they have made that clear.  Hopefully that will allow us to limp along.  But I am really starting to worry about the possibility of a stagnant economy for many months if the normal lending channels are not unclogged very soon.

For the last few days, I've been listening/reading rather than talking/writing.  Reflecting on what I have read and heard, there is one thing that stands out.

Everybody's got their own idea of how they would fix the financial markets.

Some are actually pretty good and might even work better than what we'll probably get.  Others sound good but probably wouldn't work in practice.  Others are downright nonsense.

But the purpose of this post is not to list and categorize all of the proposals floating through the blogosphere.  Nor will I offer a complete proposal of my own.  Rather, I just want to offer a few general observations.

I'm generally in favor of getting this toxic paper off of the balance sheets of the banks in the interest of unclogging the system and restoring a sense of normalcy in the markets.  I am genuinely concerned about what could happen if the banks continue to hold this paper for a long period of time.  The crisis of confidence and the inability to lend would lead to a stagnation not unlike Japan in the 1990s.

So if we agree to take this paper off the books of the banks, the next step is to agree on a way of valuing that paper.  Given that the market for this paper is not functioning very well, price discovery is a challenge.  The government would be making the market, and being the only buyer of any consequence, you'd think that they would be able to buy the paper at a pretty good discount.

But...

If the government buys the paper at fire sale prices, you still have the solvency problem and many financial firms could go under.  While many folks may not lose a lot of sleep over this, there still is the matter of making sure that the market participants are on sufficient footing to move forward in the aftermath.  With lots of insolvent firms out there, credit will still be constrained.

Since fire sale prices will not cure the insolvency problem and since paying more than market prices means taxpayers are more likely to lose, there is a reason to look for another way.  It would not be out of line to require troubled institutions to give up some equity in return for the above market price on the assets.  That way, the shareholders will bear some of the cost--as they should.

It is also not out of line to demand management changes and a reduction of the "golden parachutes".  I am not against multi-million dollar salaries for CEOs whose leadership is valued by the market.  But I do believe that some of the cases we have seen recently are evidence of a collective action problem in which the shareholders have been unable to exert the optimal level of control over compensation issues.  In the long run, that's a problem that deserves more study.  In the short run, in the case of insolvent firms dumping their toxic paper, a more direct approach may be in order.

I'm not against having the firms being "bailed out" suffer a little pain in the process.  But for the sake of the system, that pain cannot be so severe that it threatens the ability of the firms to function in the future.  If you're looking for my bottom line, there it is.

There will have to be regulatory changes going forward.  However, it is impractical, and I believe folly, to require those changes as a condition to passing this "bailout" package as some in Congress would like.

The world markets are watching.  At the moment, the world markets are extending their forbearance to us as they wait to see how we are going to handle the solvency crisis that now looms large even as the liquidity crisis enters its end game.  They have been very patient with their forbearance.  But if inaction means a significant risk of catastrophic failure of these institutions, then the world's patience will wear thin.  And that's a scary thought.

So I am fairly confident that a "workable" solution will be reached before the markets open on Monday.  I do not look for an "optimal" solution.  If an optimal solution exists, it is undoubtedly too complicated to be "workable".  But I believe that a number of ideas on the table have the potential to avert a complete meltdown.  I think that when all the parties (including both McCain and Obama) meet behind closed doors and really come to grips with the magnitude of the problem and the fact that a workable solution exists, we'll get one.

I sure hope I'm right.

By the way, today's award for the best job of explaining the consequences of inaction and the issues inherent in the different approaches to a solution goes to Peter Orszag of the CBO for his testimony to the House Budget Committee.  His complete statement is on the CBO Director's blog.  Excellent explanation.

From the NY Times:

Sweden did not just bail out its financial institutions by having the government take over the bad debts. It extracted pounds of flesh from bank shareholders before writing checks. Banks had to write down losses and issue warrants to the government.

That strategy held banks responsible and turned the government into an owner. When distressed assets were sold, the profits flowed to taxpayers, and the government was able to recoup more money later by selling its shares in the companies as well.

Worth a look.

Here's the NY Times article explaining it.  Calculated Risk explains why it's not quite like the RTC.  Actually, the buying of distressed mortgages from banks that don't want them sounds more like the original Fannie Mae.  There is an important difference from Fannie Mae in that this does not appear to be permanent.  Its temporary nature is one point of similarity with the RTC.  I think we'll just have to wait and see what it looks like when it's all said and done.

I haven't had time to think about it enough to have an opinion.  I'll probably wait until the details are out.  I do have some questions though.  One thing I don't have a feel for is how much of a discount will be taken when the government purchases these assets and what they'll be worth when the government sells them.  Just how quickly will the plan restore these balance sheets to something approaching normal?  For all the attention the other interventions have received, this one has the potential to really be The Big One.

Doesn't the fact that overseas markets are surging in response to this make you the least bit nervous about how this will be interpreted?

What will become of the $70 billion private liquidity fund?  Will it even be tapped now that The Big One is on the horizon?

My working hypothesis is that the connectedness of the markets made this simply impossible to unravel piece-by-piece.

It's been a while since I've said this, but my sentiment right now is approximated most closely by Paul Krugman's latest column.  Go.  Read.  Understand.

This one comes from Lawrence White at Division of Labour.  It's a Forbes article on the Shadow Financial Regulatory Committee (which is sponsored by the American Enterprise Institute).

Washington, D.C. -

An independent panel of academics Monday cautioned Washington against rushing into an innovation-stifling regulation of investment banking, but urged that structures be put in place to ensure the industry itself bears the cost of any future federal bailouts.

The Shadow Financial Regulatory Committee also took a stand against new restrictions on short-selling and recommended that the government liquidate Fannie Mae and Freddie Mac once the market for mortgage financing has stabilized. The federal government took over the two quasi-private mortgage giants earlier this month.

...

The committee noted approvingly that the Federal Reserve Bank of New York has been pushing industry players to create a central clearinghouse for credit default swaps and other derivatives. In a clearinghouse model, Calomiris said, investment banks would share the costs of a member's default, thus creating an incentive to enforce capital standards and to demand more transparency from other participants.

The committee also recommended that the federal government levy a special assessment on investment banks to pay for any future industry bailouts, thus giving the bankers an incentive to support federal intervention only when a failure would present a true risk to the financial system.

The model for this, the committee noted, was established when Congress passed the Federal Deposit Insurance Corporation Improvement Act of 1991.

...

The $70 billion liquidity fund that 10 financial institutions, including Citigroup, Credit Suisse and Deutsche Bank, agreed to set up over the weekend was an acknowledgment by these institutions that it's appropriate for them to share losses to contain systemic risk, the committee noted.

In his post, White adds:

If the Fed and Treasury are now giving a de facto guarantees to the creditors of investment banks (as in the Bear Stearns intervention), why not require the Fed or Treasury to recoup the cost through an assessment on all investment banks? That would insulate ordinary taxpayers, and it would give healthy investment banks an incentive to oppose unnecessary bailouts. Ditto for guarantees to the creditors of insurance companies (as in the AIG nationalization).

It is a bad idea to extend federal guarantees to the creditors of investment banks and insurance companies. First-best is to let those industries organize their own cross-supports (on the model of pre-Fed bank clearinghouses) if they think it worthwhile. But extending federal guarantees to an industry at a zero price, subsidized by ordinary taxpayers, is the worst idea of all.

I could certainly get behind such a proposal going forward.  The liquidity fund setup over the weekend is definitely a step in the right direction.  To the extent that the Fed and Treasury used moral suasion to make it happen, they deserve some credit.  Providing government guarantees to insurance companies is not something that I like to see either, but I'm willing to give the benefit of the doubt to the front line troops in the heat of battle.  I would agree that for the next firm in this position, the Fed and Treasury need to lean on them really hard to use the private liquidity fund.  I mean really hard.

Another good comparison that may be more familiar to people would be the way that we fund unemployment insurance.  Unemployment insurance is funded by a tax on employers that is experience rated.  That is, firms that have more layoffs are taxed more heavily.  Likewise, the government could set up an assessment (i.e. tax) on investment banks, perhaps even make it dependent on an audit of their financial position and transparency.  I think that idea deserves some attention.

There is a way forward.  And it is definitely appropriate to start thinking creatively about ways to prevent the moral hazard which could lead to another crisis.  The door is broken and the cows are out of the barn.  Our first priority is rounding up the cows, but it doesn't hurt to put a few smart minds to work on the problem of fixing the door--it may even keep in some of the cows that have not yet escaped.

Here's an interesting comment from the WSJ MarketBeat blog:

"With this move the Fed and Treasury have blinked in the face of market pressure once again," writes Drew Matus, economist at Merrill Lynch. "They continue to react to situations rather than getting in front of them and now they have created uncertainty about what firms qualify for bailouts and which do not."

Let's think about this.  If there was an easy way to tell which firms pose the most potential for systemic risk and if the Fed started to "get out in front" of those situations, what do you think the result would be?

Yeah.  Not pretty.

A little uncertainty is a good thing here.

The other important thing to remember in all this is that the size of the AIG "bailout" may be much less than the $85 billion that has people worked up.  This is really just an extension of the Fed's credit facilities that have always been available to commercial banks and have recently been extended to investment banks.  AIG would not qualify for such help from the lender of last resort, but the harm to the system from its failure would be at least as great as the harm from failures of a traditional bank.  Therefore the Fed used its emergency power to extend that credit to them.  AIG will essentially reorganize as if it were going through bankruptcy but without the agony to the system that a bankruptcy would cause.  There's a very real probability that the Fed could come out ahead on this deal.

Tyler Cowen explains why no one else was willing to do it, and Felix Salmon also agrees with me on the possible upside.

The next big problem in the short term is getting the money market through all of this.  No sighs of relief until they are, at least temporarily, out of the woods.

Here's the statement from the Fed:

The Federal Reserve Board on Tuesday, with the full support of the Treasury Department, authorized the Federal Reserve Bank of New York to lend up to $85 billion to the American International Group (AIG) under section 13(3) of the Federal Reserve Act. The secured loan has terms and conditions designed to protect the interests of the U.S. government and taxpayers.

The Board determined that, in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance.  

The purpose of this liquidity facility is to assist AIG in meeting its obligations as they come due. This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy. 

The AIG facility has a 24-month term. Interest will accrue on the outstanding balance at a rate of three-month Libor plus 850 basis points. AIG will be permitted to draw up to $85 billion under the facility. 

The interests of taxpayers are protected by key terms of the loan. The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries.  These assets include the stock of substantially all of the regulated subsidiaries.  The loan is expected to be repaid from the proceeds of the sale of the firm's assets. The U.S. government will receive a 79.9 percent equity interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders.

The Wall Street Journal gives a very thorough rundown of all the details.

Opinions are surely going to be divided on whether this is a good thing or not.  John Jansen sees the Fed as "careening down a very slippery slope".  I have a feeling that most commentators will be against it even though their specific reasons will differ.

Mark Thoma thinks it is a good idea.  And while I would have rather seen them tap the private equity market, something had to be done.  Recall that AIG has been turning down private assistance for the last couple days because they didn't want to give up control of the company.  With the Fed deal, they will surely give up some control, but exactly what the company will look like going forward remains to be seen.

Is it a bailout?  Is it a takeover?  To me it looks more like bankruptcy by another name.  Effectively it gives AIG some time to sell a lot of its assets--more than just the junk--and reorganize itself.  In the meantime, its creditors will be made whole.  Equity holders may properly bear some of the cost as the government has veto power over dividends.  At the end of the 24 month period...hopefully...the company, in whatever form it takes, can resume something approaching normalcy.  Assuming, of course, that it has any reputation left.  Perhaps sometime during or after that 24 months a suitable buyer can be found.  These are questions that no one can answer now.

Make no mistake, this is not something that the Fed should enter into lightly, and I am quite confident that they took this step only when it became apparent that it was the last option.  But this might have been one of those turning points where a decisive action had to be made.  Anyone who has not read chapter 7 of Friedman and Schwartz needs to do so right now.  Every time I tell a macroeconomics class about the mistakes the Fed made in the Great Depression, I end by talking about the many things we have learned since then about how not to let it happen again.  Few people know those lessons better than Mr. Bernanke.  Dithering in the face of these problems only makes them worse.  Better to have swift decisive action and move toward a resolution.

To those who say that this fails to properly punish those who took excessive risk, I agree in part but can only say that protecting the innocent (or perhaps less guilty) is more important right now than punishing the truly guilty.  To those who would say that this is an affront to the free market system, I would simply say that without confidence in market institutions the system doesn't work.  The system's ability to restore that confidence has been compromised by the foolish actions of many people.  Some will get their comeuppance.  Some will not.  It's not a perfect world.  We'll try to reform the system so as to do better next time.  Right now let's focus on doing it better than last time.

In a nice commentary, Calculated Risk appears cautiously optimistic.

There will be more grim news, perhaps for another year or more. And there is definitely some possibility of a systemic financial collapse (see Professor Roubini's excellent discussion of the downside risks). But unlike observers that believe this only marks the end of the beginning, I believe there is a chance that these events mark the beginning of the end of the crisis.

As I said yesterday, I think the end game has begun.  Clearly the push to mark down the values of these assets is in full swing.  The AIG deal could be a catalyst for an orderly sale of these assets, a rebalancing of portfolios, and a fair market valuation of assets on the books of other firms.  In the process, we might find other AIGs, but more than likely any of the truly enormous problems will be discovered first, and that process may not take too long.  Several months, perhaps--but not several years.  Indeed, we are fortunate that these problems are being discovered and dealt with rather than festering for a decade or more.

I've been in class all day, so I haven't had a chance to write about the days events.  Actually, there's not that much more to say other than that I really admire the fact that the Fed held the line on interest rates today.  As I said yesterday, the crisis is one of quantity, not of price.  The new lending facilities are much more important and useful than a 25 basis point cut in the funds rate.  So my confidence has been buoyed by this news.

Here's the link to the Fed's press release.

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent.

Strains in financial markets have increased significantly and labor markets have weakened further. Economic growth appears to have slowed recently, partly reflecting a softening of household spending. Tight credit conditions, the ongoing housing contraction, and some slowing in export growth are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.

Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.

The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Christine M. Cumming; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Ms. Cumming voted as the alternate for Timothy F. Geithner.

My quick take is that it is very noncommittal about whether any rate cuts are forthcoming.  The inflation pressure still figures prominently in the press release, though they do expect inflation to ease.  This is an announcement that leaves all avenues open--and that is a very good thing.

In my intermediate macro class today, I lectured against a backdrop of the live (well, actually slightly delayed) tick-by-tick chart of the fed funds futures on the CBOT.  I was teaching macroeconomics as it happened.  You don't get to do that very often.

Seems like the big questions on everyone's mind are whether there will be some kind of development with AIG tomorrow, which firms are most exposed to Lehman, and whether the Fed will cut interest rates.  It goes without saying that everyone is also wondering about whether and how much the Dow may fall.  As I write, the futures market is down, but not drastically, suggesting that the day may start on a down note.

I can't say much about the first two.  But let's think about the Fed for a minute.  When I wrote in the afternoon, it looked like the market was only pricing in a small probability of a rate cut.  Late night coverage on CNBC suggests that the probability has increased substantially now.

The Wall Street Journal acknowledges the uncertainty:

Federal Reserve officials aren't inclined to veer from plans to hold short-term interest rates steady at Tuesday's meeting, even though financial markets are putting strong odds on a quick rate cut.

The Fed's thinking could change, particularly if there is another sharp deterioration in markets and the financial sector Tuesday. And even if officials decide to stay on hold, they could signal in their end-of-meeting statement a greater willingness to consider rate cuts if the economy or markets worsen.

A rate cut would be a confidence booster, to be sure.  Ordinarily, one might expect a rate cut in this case would prevent the financial market problems from spreading to Main Street.  I'm not sure that 25 basis points (or even 50) would really have much of an effect in that regard.  Plus, if the Fed were to cut 50 b.p. tomorrow (as some are expecting), it leave only another 1.50% to go before hitting the zero lower bound.  Given that this could go on for a while, it is imperative that they hold back some ammunition just in case things get much worse.

But most importantly, I don't see how 25 points (or even 50) does anything substantial to ease the credit crisis that the expansion of the quantity of credit through the various lending facilities can't do.

In the end, they may decide that a 25 or 50 point move is necessary to inspire confidence.  I would like to think that in the last year the market has wised up in that regard and can understand that this problem will not be solved by a rate cut any time a financial firm runs into trouble.

These are momentous times, the likes of which we will be talking about for years to come.

I watched the press conference with the John Thain and Kenneth Lewis (CEOs of Merrill Lynch and Bank of America, respectively) as well as the CNBC interview with Lewis.  Mr. Lewis looked like the cat that ate the canary.  He certainly gives the impression that this is the deal of a lifetime.  Who knows?  He may be right.

At this point, I have begun to make a few inferences.  We'll see how accurate they turn out to be.

1. Based on CNBC's reporting, it sounds like Merrill Lynch really cleaned up their act (and their books) in the last few months.  They make it sound like Merrill might have even been able to survive this crisis without being sold.  That's encouraging.  Perhaps some of the other firms that are in less dire condition may be able to heal themselves, even if it takes some time for it to all work out.
2. Either Lehman's position in the market must have been significantly different than that of Bear Stearns a few months ago, or the market is better equipped to deal with a failure of that magnitude.  Both could be true as well.  There was no cataclysmic market meltdown this morning.  Contrast that with the speculation on what might have happened this spring if Bear Stearns had declared bankruptcy.  This is also encouraging.
3. Remember when people criticized the Fed for taking part in the rescue of Bear Stearns?  Remember when people said that it would create moral hazard and make it difficult for the Fed to say no next time?  Well, apparently the Fed is stronger than a lot of people gave them credit for.  While I don't think Mr. Bernanke expected it to play out exactly this way (who would have?), I do applaud him for taking the action with Bear Stearns to prevent the first incident from being such a shock to the system.  A lot of people wanted a sacrificial lamb.  Mr. Bernanke may have been correct in thinking that a better candidate than Bear Stearns would come along.
4. AIG's potential collapse sounds like it would have a greater impact than Lehman's.  I think the Fed is right to hold the line.  The announcement from the governor of New York will help.  The growing pool of private equity might help too.  And of course someone might ride to their rescue as well.
5. Expect another year of write-downs, bankruptcies, and mergers.  But I think that the end game has begun.  By that, I do not mean that the danger is over or that things will get eaiser.  When I say that the end game has begun, I mean that the deals will start happening at a quicker pace in the next 12 months than in the last 12 months and that each one will bring a bit of relief, however slight.  The financial markets will probably not be over this until 2010, and even then they won't be at pre-crisis strength.

So then there is the matter of the FOMC meeting tomorrow.  September futures on the Chicago Board of Trade jumped a little bit this morning on all of the news, but have pulled back a bit.  Traders are pricing in a significant probability of at least a 25 basis point cut.  However, it is far from a sure thing.  I'm hoping they don't.  I don't think they want to.  The expansion of the various lending facilities should do more to ease the strain than a 25 basis point cut anyway.  Plus there is the obvious fact that they would like to save some ammunition in case it is needed later if things don't play out as well as they might.

Let's see how things go tomorrow.

It certainly says something when firms that survived the Great Depression are falling victim to the aftermath of the last decade's credit binge.

And so the venerable Lehman Brothers passes from the scene at the age of 158.  When the sun rises in the morning, we will see how Wall Street deals with this development.  Of course, many people were expecting this, and undoubtedly made contingency plans.  By Friday, it seemed that a Sunday night announcement was almost a sure thing.  After all, we went through this once before with Bear Stearns.  Yet, even though this was possibility for the past few weeks and months, it is now reality.

It is interesting that Bank of America, which as of Friday many people were expecting to buy Lehman, took a pass on that deal and is instead buying the troubled (and storied) Merrill Lynch.  How's that for misdirection? 

But that's not all.  Showing once again that bad things do indeed come in threes, the insurance giant AIG is also in need of assistance.

With these three companies in such dire straits, the Federal Reserve did what it could... quoting in part:

The Federal Reserve Board on Sunday announced several initiatives to provide additional support to financial markets, including enhancements to its existing liquidity facilities. 

"In close collaboration with the Treasury and the Securities and Exchange Commission, we have been in ongoing discussions with market participants, including through the weekend, to identify potential market vulnerabilities in the wake of an unwinding of a major financial institution and to consider appropriate official sector and private sector responses," said Federal Reserve Board Chairman Ben S. Bernanke. "The steps we are announcing today, along with significant commitments from the private sector, are intended to mitigate the potential risks and disruptions to markets."

"We have been and remain in close contact with other U.S. and international regulators, supervisory authorities, and central banks to monitor and share information on conditions in financial markets and firms around the world," Chairman Bernanke said.

The collateral eligible to be pledged at the Primary Dealer Credit Facility (PDCF) has been broadened to closely match the types of collateral that can be pledged in the tri-party repo systems of the two major clearing banks. Previously, PDCF collateral had been limited to invest